401(k), IRA and HSA: How US Retirement Accounts Cut Your Tax

The American tax code offers no larger legitimate saving to an ordinary earner than tax-advantaged retirement accounts. Contributions to traditional accounts reduce taxable income in the year they are made; Roth contributions are made from taxed income but grow and are withdrawn tax-free. Choosing between them is the central decision, and for most people the answer is to hold some of each.

A workplace 401(k) or 403(b) accepts elective deferrals up to an annual limit, with an additional catch-up amount once you reach 50. Contributions are taken from pay before income tax — though not before Social Security and Medicare tax — so a $10,000 deferral by someone in the 24 per cent bracket reduces the current federal bill by $2,400. Limits are adjusted annually, so confirm the current figure rather than reusing last year's payroll election.

If your employer matches, that portion is the highest-return investment available to you and should be captured before any other saving goal. A 50 per cent match on the first 6 per cent of pay is an immediate 50 per cent return on that money. Declining a match to pay down low-interest debt is almost always the wrong order of operations. Check the vesting schedule so you know how long you must stay before the match is irrevocably yours.

IRAs run alongside workplace plans with their own, smaller limit. Traditional IRA contributions are deductible, but the deduction phases out at higher incomes when you or your spouse are covered by a workplace plan. Roth IRA contributions are subject to income limits of their own. Higher earners often use the so-called backdoor Roth — a non-deductible traditional contribution followed by a conversion — which works cleanly only if you hold no other pre-tax IRA balances, because of the pro-rata rule.

The traditional-versus-Roth choice turns on the comparison between your marginal rate now and your expected rate in retirement. Early-career earners in the 12 per cent bracket generally favour Roth, since the deduction is worth little and decades of tax-free growth are worth a great deal. Peak earners in the 32 to 37 per cent brackets usually favour traditional, expecting to draw the money in retirement at a lower rate. Anyone uncertain should split contributions, which also creates flexibility to manage taxable income in retirement.

Health savings accounts deserve their reputation as the most tax-efficient vehicle in the code. If you are covered by a qualifying high-deductible health plan, contributions are deductible, growth is untaxed, and withdrawals for qualified medical expenses are untaxed — a triple advantage no other account offers. Contributions made through payroll also escape Social Security and Medicare tax. After 65 the account behaves like a traditional IRA for non-medical withdrawals, so unspent balances are never stranded.

The self-employed have access to larger vehicles. A SEP-IRA allows contributions of up to a quarter of net self-employment earnings within an overall cap. A solo 401(k) permits both an employee deferral and an employer contribution, usually producing a higher total at moderate income levels, and can accept Roth deferrals. The plan generally needs to exist before the end of the tax year even if it is funded later, which makes December the deadline for a decision that pays off in April.

Withdrawal rules matter as much as contribution rules. Distributions before 59½ generally trigger a 10 per cent penalty on top of income tax, with exceptions for first home purchase, higher education, birth or adoption, certain medical costs and substantially equal periodic payments. Required minimum distributions begin in your seventies for traditional accounts. Roth IRAs have no lifetime required distributions, which makes them the natural place to leave money for heirs.